Capital Budgeting: Wrapping It All Up

All for-profit business seemingly exist on the mandate of maximizing shareholder, or owner, value. A business is essentially a series of transactions that aim at generating greater revenue and profits. The capital budgeting process, or the methods employed by a company to invest in activities to generate additional value, is a dynamic process, to say the least.

In a way, a business is nothing more than a series of many capital budgeting decisions. Decisions to hire a new CEO, negotiate contracts, maintain efficient operations, compete in the mergers and acquisitions arena, among others, are all capital budgeting decisions, in one way or another. Even decisions to reduce employees, shut down a division or the sale of part or all the company are capital budgeting decisions. Businesses are often observed being sold under the mandate of maximizing shareholder value.

Whether minor or major, all business decisions involve an accounting of costs versus benefits. In a way, that's the essence of the capital budgeting process. Shareholders put their trust in management to constantly assess the costs versus benefits – the risk versus the reward – of their corporate actions. When a CEO is fired, it's often because a company has failed to create shareholder value. Put another way, that CEO or executive has failed to successfully engage in value-creating projects; the capital budgeting process under that CEO was ineffective.

Understanding the capital budgeting process is not only important from an intellectual standpoint, but vital to understanding how a business can and will create future value. The world's greatest executives – Sam Walton of Wal-Mart, Roberto Goizueta of Coca Cola, Warren Buffett at Berkshire Hathaway, Jack Welch at General Electric – have a long history of making value creating decisions. These executives got capital budgeting process right.

Individual investors also benefit from the capital budgeting process. Investing in a company's stock is much like investing in a project. At a given share price, investors ought to be able to figure out if that share price is below the intrinsic value of those shares. One determines the intrinsic value by conducting a discounted cash flow analysis, essentially finding the net present value of that company. Being able to seek out undervalued investments is clearly the ultimate objective for investors and corporate executives. In one form or another, the capital budgeting process is the set of tools that facilitates that value seeking process.